Mental Accounting Essay

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Mental  accounting can be thought of as the intersection of behavioral psychology and economics.  It is the  discipline  that  examines  how people  think  about  money  and  financial transactions,  in  an  effort  to  find  ways  for  the thought processes  and  the  operation of  financial instruments to  be  brought into  closer  alignment with each other, so that people experience more positive  outcomes.  This field can be a challenging one because its focus is on a system that continually reshapes  itself: People’s manner  of thinking  about money  affects the way they use money, but  at the same time, the opposite is true—the way people use money affects how they think  about  it. Ultimately, the  reason  why  social  scientists  are  interested  in mental  accounting is  because  it  provides  insight into  the  psychology  of choice:  how  people  make decisions  in  the  allocation of scarce  resources  to satisfy a diverse array  of needs and wants.

A sizable portion of the study of mental accounting is devoted to determining the reasoning that  causes  many  people  to  act  contrary to  their interests, and even to their expressed intentions, in matters  of finance.  For example,  most  people  are aware that they should save money for unforeseeable emergencies, that  they should  avoid  overspending and taking on large amounts of debt, and that they should invest their money in the assets that provide the  greatest  amount of return  at  the  lowest  risk.

Nevertheless,  the  vast  majority  of  consumers  do not   follow   any  of  these  strategies   consistently, instead  rationalizing, procrastinating, and  making excuses for not doing what they know they should do.  Mental   accounting studies  the  reasons  why people do these things, and it also analyzes the mechanisms  they use, such as claiming not to have enough  time or money.

Mental  accounting had  its origins  in the work of  the  economist  Richard  Thaler,  who  observed that   people   tend   to  think   of  their   finances   in separate amounts and each amount is differentiated by a special purpose  (and  often  by a level of risk that   the   person   considers   acceptable   for   that amount). Contrary to common sense, which would suggest that all of one’s funds are identical and interchangeable, mental  accounting shows that people think  of some money as being set aside for “safe” purposes, while other money can be used in a more risky fashion, such as investing in the stock market, purchasing lottery  tickets, or gambling.

One of the principles of economics  is known  as fungibility. Fungibility means that a resource is interchangeable, as with currency—one  dollar  can be substituted for  another; if one  wishes  to  save $100 from a $500 paycheck for a vacation  fund, it doesn’t  matter  which  hundred dollars  of the  five hundred are saved, because  they are all the same. Mental  accounting involves choices that seem contrary to common  sense precisely because  such accounting contradicts the  concept  of fungibility, by treating  different  amounts of money  as if they had unique functions and qualities. A person might view  his  or   her   paycheck   as  a  collection   of such  amounts: $50  for  the  water  bill,  $100  for electricity, $1,000 for rent, and so forth.

Framing

One  of the foundations of mental  accounting theory is the concept of framing. Framing refers to the ways we choose  to look  at an issue. The way we frame an issue largely determines how we feel about that issue and how we will behave in circumstances where that issue is a situational factor. For example, there are at least two ways of framing  the issue of the  cost  of  life  insurance.   One  way  to  frame  it would  be to see it as a financial  burden  that  may never be of any use, and even if it is of use, it will be when one is dead and beyond  the need for money. On the other hand, one could also frame the cost of life insurance  as providing  a deep and abiding sense of peace, as one can rest assured  that  one’s family will be provided  for in the event of one’s death.

Framing affects almost every aspect of our interactions with  money,  especially  when  two  or more  people  are  cooperating to  allocate  limited financial  resources,  because  different  people  are likely  to  frame  a  given  transaction  in  different ways. A husband out shopping  with his wife might see that  the $500  set of golf clubs he has had  his eye on are on sale at a 50-percent  discount. He will frame  this as a huge savings and  will be eager to take advantage of the deal. His wife, on the other hand,  may frame the situation as a large purchase (e.g.,  $250)   that   they  cannot   afford   right  now. Experts  in mental  accounting are  accustomed to helping  people  reconcile  contrasting frameworks like these.

Spending Sources

An  interesting   application  of  mental   accounting arises when one studies the different behaviors  people exhibit depending on what type of spending they are doing and what they are spending on. Regarding the type of spending, the largest difference seems to be between  the behavior  of those who spend using credit cards and those who use cash. This is usually attributed to the fact that cash represents  a concrete value that  is easier to keep  track  of as it is spent, while credit cards  allow one to just swipe the card and hurry  off on the next errand, without spending too much time considering  what has been spent.

Regardless   of  what   funds   we  use  to   make purchases,  there  are  some  goods  and  services that people tend to spend more on than they might intend to. Many  of these are related  to traditions, to issues that have major emotional significance, or both. Expenses that implicate both of these motivators are weddings  and  funerals—in  each  situation, we  are under great pressure to demonstrate the depth of our feelings through the amount that  we spend  and  to maintain ties with past generations by holding events that compare  with theirs in grandeur.

Review Of Accounts

Mental  accounting takes  note  of  how  often  one reviews  accounts  and  confirms  the  balances  they contain.  This  can  be done  on  whatever  schedule the circumstances require  (daily, weekly, monthly, annually),   but  the  frequency  has  an  impact   on one’s spending  patterns and  one’s perceptions of that   spending.  Those  who  check  their  accounts more frequently will spend with greater confidence because their knowledge about  the funds they have available will be more complete  and more current, yet this  may  cause  them  to  spend  less than  they would  otherwise.   Consumers who  balance  their accounts  less frequently  often have greater  anxiety levels  about   money   (the  anxiety   is  typically   a major factor deterring them from more frequent account  reconciliation).

Reviewing accounts  has a separate  significance in  mental  accounting. It  also  refers  to  the  ways consumers  categorize  different  expenses  and  the way they think about  individual  purchases  as they assign them to these categories.  Most  people who pay more  than  cursory  attention to their  finances develop some method  of tracking  how much they spend on different areas of their lives: housing, utilities,  clothing,  food,  entertainment, and  many other categories. Often consumers will have categories particular to their own interests but that would not be useful to most other people. A collector of rare manuscripts, for example, might categorize her budget and set aside different amounts for “folios,” “quartos,”  and   “octavos,”  while   an ordinary person could get by with one category for “books.” The types of categories that people create tell  us  how  people  think  about  the  money  they spend. The same is true of how people characterize transactions  as  belonging   to   one   category   as opposed   to   another.  A  successful   entrepreneur might  put  tickets  to  the  opera  in the  category  of “business  expense”  if he took  along a prospective client, but if he took  his wife instead,  the category might be “entertainment.” Depending  on his situation,  he  might  feel  less  guilty  about   a  business expense  than  about  more  discretionary spending on an enjoyable  evening with  his spouse. Each of these internal  calculations and judgments  is a potential goldmine  of  insight  for  the  student   of mental  accounting.

Types  Of Value

Part of the internal  calculations we engage in during mental  accounting is  centered  on  the  differences between  the two  different  types of value we attribute to the act of purchasing a good or service. The one that  most people are familiar  with is called the acquisition value. This is the amount of money that the purchaser is willing to give up in exchange  for obtaining ownership of the good or service; in other words,  it is what  we think  of as a fair price for the commodity. Depending   on  many  factors  such  as personality, need, stress level, and so forth, two different people are likely to assign very different acquisition values  to  the  same  product or  service. For example, sports fans would assign a high acquisition value to tickets for seats on the 50-yard  line at the Super Bowl, while those not interested in such events would assign a much lower value or no value at all.

Separate and distinct from the acquisition value of a transaction is the transaction value the purchaser assigns to that  transaction. Transaction value,  rather   than   an  indication  of  one’s  belief about  what  constitutes  a fair price, is an indicator of how good a deal the purchaser believes she has got. It is important to realize that  this has nothing to do with the amount being spent—it is a function of the difference between what  the purchaser pays and what the purchaser believes she should ordinarily  expect   to   pay.   If  this   difference   is positive, it means  that  the purchaser believes that she has paid less than  she would  have expected to, while  a  negative  sum  for  the  transaction value indicates that the purchaser feels she has paid more than  she should  have.

Both  acquisition  costs  and   transaction  costs play a significant role in mental accounting because they are factors  in how people spend their money and   how   they  view  the  act  of  spending   it  in particular circumstances. These issues are also very important for those  who  are selling products and services,   because   sellers   want   to   make   their offerings coincide as much as possible with consumers’  thinking  about  acquisition and  transaction  costs. This is why companies  look  at both their own costs and their competitors’ prices when deciding   how   much   to   charge   for   goods   and services. The ideal price point  for a commodity is one that  is slightly below the competition but well above the overhead. Placing the price above the overhead   obviously   means   that   each   sale  will generate  a profit,  but placing the price below that of the competition will make  purchasers  feel that they are getting a good deal (because competitors’ higher  prices  will give the  impression  that  those higher prices are set at what the price really should be), that is, their transaction value for the purchase will tend  to  be positive.  Sellers want  to  sell their products at  prices  near  buyers’  acquisition value (the price they feel they can and will pay) and at a point   that   will  give  buyers   a  high  transaction value.

Bibliography:

  1. Camerer, Colin, George Loewenstein,  and Matthew Rabin. Advances  in Behavioral  New York: Russell Sage Foundation, 2004.
  2. Dreman, David N. Contrarian  Investment Strategies: The Psychological  New York: The Free Press, 2012. Hastings,  Justine S. and Jesse M. Shapiro. Mental
  3. Accounting and Consumer Choice: Evidence From Commodity Price Shocks. Cambridge, MA: National Bureau of Economic Research, 2012.
  4. Nicholson, Colin J. Think Like the Great Investors:  Make Better Decisions and Raise Your  Investing  to a New Level. Richmond, Victoria, Australia:  John Wiley & Sons, 2013.
  5. Nofsinger, John R. Investment Madness: How Psychology Affects  Your  Investing  and What  to Do About It. London:  Financial Times Prentice Hall, 2001.
  6. Pompian, Michael M. Behavioral Finance and Wealth Management: How  to Build Optimal Portfolios  That Account for Investor  Hoboken, NJ: John Wiley & Sons, 2006.
  7. Wilkinson, Nick and Matthias Klaes. An Introduction to Behavioral  Basingstoke, UK: Palgrave Macmillan, 2012.

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